I am having troubles with question 2 part c and d, I hope someone can provide me answers to these questions

1 Last Name: ___________________________________________________________________ First Name: ___________________________________________________________________ S.I.D: ________________________________________________________________________ THE UNIVERSITY OF SYDNEY ECOS 3021 Business Cycles and Asset Markets MIDSEMESTER EXAMINATION September 2013 Instructions: ______________________________________________________________________________ Time allowed: 80 minutes (including reading time). The exam consists of 2 sections. Section I includes 10 multiple choice questions worth 40 marks in total. To answer in this section, mark the letter representing the best response on the accompanying multiple choice answer sheet. You must use a pencil for the machine to be able to read your answer. You may use a dark ball point pen, if you do not have a pencil but you will not be able to correct your answer. Section I will be worth 40% of the total exam mark. Section II includes 2 short answer questions worth 60 marks in total. You should answer all questions. Your answer should be given in the space provided right below the questions. Any answer written outside the space provided will not be marked. Note that this exam is worth 25% of the total mark from this unit of study. This is a closed book test. Non-programmable calculators may be used. No other aides are allowed. The exam may not be removed from the room. You should remain seated during the first 30 minutes and last 20 minutes of the exam. ______________________________________________________________________________ 2 Section I: Multiple Choice Questions. Choose the best response. 1. Which of the following statements about the business cycle is correct? a) Business cycles exhibit regular cycles of boom and bust and hence are periodic. b) Expansions and contractions are symmetric in duration. c) Business cycles are essentially focused on short-run macroeconomic fluctuations not exceeding a year. d) Australia has not had a classical recession since the 1990-91 recession. 2. Which of the following is a reason for detrending the (log) level of real GDP? a) To identify a recession as measured by an absolute decline in output for two successive quarters or more. b) To remove the effects of long-term trend on short- and medium-run movements in output. c) To identify turning points in the aggregate economic activities. d) To compute the durations of expansions and contractions. 3. If the labour market is in equilibrium, a) the marginal rate of substitution between consumption and leisure equals the real wage. b) the marginal product of labour equals the real wage. c) both marginal product of labour and marginal rate of substitution between consumption and leisure must be equal to the real interest rate. d) the marginal rate of substitution between consumption and leisure equals the marginal product of labour. 4. Which of the following is not predicted by the technology shock driven real business cycle (RBC) theory? a) b) c) d) Real wage is acyclical. Productivity is pro-cyclical. There is no involuntary unemployment. Consumption is smoother than output. 5. Suppose that the price-dividend (P/D) (or dividend-price (D/P)) ratio is a good predictor of the future stock returns, and you are about to estimate the following empirical model on a long time series data, We would then expect the following estimation results: a) b) c) d) the sign of a to be positive and the sign of b to be negative. the sign of a to be negative and the sign of b to be negative. the sign of a to be positive and the sign of b to positive. the sign of a to be negative and the sign of b to be positive. 3 6. Assume that the aggregate labour market is such that the labour demand curve is upward sloping and steeper than the labour supply curve. If pessimistic expectations are wide spread among workers in an economy with this type of labour market, a) b) c) d) real wages will fall while aggregate output will increase. aggregate output will fall while employment will increase. it is possible to have an equilibrium of high real interest rate and low aggregate output real wages will fall while aggregate output does not change. 7. Political business cycles are most likely to arise in an economy in which a) policymakers have adaptive expectations while economic agents form expectations rationally b) policymakers are rational while economic agents have adaptive expectations c) policymakers are targeting the natural rate of unemployment for any given inflation d) policymakers are not opportunistic and conduct policy by rules rather than discretion. 8. According to the consumption based CAPM (C-CAPM), we can say, other things equal, a) an asset's excess return is explained entirely by its exposure to the market risk. b) the interest rates are high if expected consumption growth is high, for a standard power utility function. c) stock return is equal to the expected future dividend payments discounted by a constant discount rate minus the constant growth rate of dividend payments. d) assets with a positive covariance with consumption growth must pay a lower average return. 9. Incorporating the habit formation in the C-CAPM will help resolve the equity premium puzzle because a) the habit formation will switch people from risk averse to risk loving investors, and hence demanding higher risk premiums. b) the habit formation increases the constant parameter 'gamma' in the utility function to an extremely high value. c) the relative risk aversion coefficient becomes time-varying and makes the stochastic discount factor volatile. d) the riskfree rate is pushed down to a negative value, making excess returns very large. 10. Which of the following statements about various theories and evidence of the business cycle is the most accurate? a) The real business cycle theory implies that minimum wage legislation can help stabilize the level of unemployment when a technology shock hits the economy. b) According to the political business cycle theory and evidence, politicians can always cause fluctuations in output for electoral gains. c) Monetary business cycle hypothesis implies that business cycles cause variations in the growth rate of money. d) The new Keynesian theory explains output fluctuation as arising due to frictions and coordination failures. 4 Section II: Short-answer questions. Answer all questions. Question 1. Consider the following table, which shows the basic business cycle facts of key macroeconomic variables for Turkey using quarterly data. (a) List the two most pro-cyclical and the two most counter-cyclical variables. (5 marks) 5 (b) Would the Turkish consumption and investment data be explained by the real business cycle (RBC) model? Why or why not? (10 marks) (c) Which variable(s) would be most severely affected by a recession? Which variable would be a good predictor of real GDP one quarter ahead? Briefly explain why. (5 marks) (d) Succinctly outline how you would go about transforming macroeconomic data to obtain statistical facts as documented in the above table. (10 marks) 6 Question 2. The C-CAPM model is based on the following equation MU (c1) = E [(1 + r) MU (c2)] , where MU is the marginal utility as a function of consumption, is the subjective time preference between 0 and 1, r is the one-period real interest rate or return on an asset, c denotes consumption in each period, and E denotes expectation. (a) Succinctly provide economic interpretations of this equation. (5 marks) (b) By re-arranging the above equation, write down the asset pricing equation (i.e. showing an expression for the equilibrium price) and show what the stochastic discount factor is. (5 marks) 7 Now assume that the utility function is given by U = ln c Let = 0.9. Suppose that c1 = 1 and c2 =1.2 or 0.8 depending on the state of the economy, as follows: Good state: Bad state: c2 = 1.2 c2 = 0.8 Probability = 0.5 Probability = 0.5 (c) Find the price q and the return r on a riskless bond which pays 1 in each state in period 2. (5 marks) Now assume that there is a stock with a payoff 1.2 allowing you to consume c2 = 1.2 in a good state and pays 0.8 allowing you to consume only c2 = 0.8 in a bad state, so that it is a claim to the consumer's total consumption stream. Note that the bad and good states have equal probabilities as before. (d) Find the price of the stock q and the expected return r (i.e. the (weighted) average of the two alternative returns) on the stock. (10 marks) 8 9 (e) Calculate the equity risk premium for the stock over the bond you found in (c), and determine the relative risk aversion for the above utility function. (5 marks) ------------------------------------------------------------------------------------------------------------------------------------------ End of the Exam Any answer written below will not be read and marked. ____________________________________________________________________________________________ ECOS3021 1 Lecture 6 Asset Prices, Consumption & the Business Cycle: Part I Aim: Review conventional asset pricing models in finance Introduce a theory of asset pricing that relates asset returns to the economic fundamentals and examine empirical issues Portfolio theory aims to analyse investors' asset demand given asset returns. The CAPM (Capital Asset Pricing Model, aka Sharpe-Lintner CAPM) is written as In words, the expected return on a risky asset i , E(ri), over the riskfree rate, rF , is correlated with the expected return on the market portfolio, E(rM), over the risk free rate. The slope parameter ('beta') captures the covariance between the risky asset and the market portfolio scaled by the variance of the market portfolio. ECOS3021 Implications of the CAPM: The risk of an individual asset is characterized by it covariance with the market portfolio. The part of the risk that is correlated with the market portfolio, the systematic risk, cannot be diversified away. Bearing the systematic risk needs to be rewarded. The CAPM decomposes an asset's return into three pieces. where 1. Beta 2 ECOS3021 3 2. Sigma Hence, total risk is decomposed as follows. 3. Alpha CAPM predicts 'alpha' should be zero for all assets. But, this intercept term measures an asset's return in excess of its risk-adjusted award. Positive is either an estimation error or may be compensating other risks. ECOS3021 To sum up, CAPM is attractive because It is simple and sensible as it is built on modern portfolio theory It distinguishes systematic and non-systematic risk It is easy to implement Limitations of the CAPM Difficult to test Empirical evidence is mixed. Bad on time series data (perhaps not surprising?) In CAPM, investors follow myopic strategies as investment horizon is short and investment opportunities are assumed to be constant over time. Multi-factor CAPM Identify \"factors\